By Ravi Mahendra

When I was in Sri Lanka recently a friend of mine who is an active investor in the CSE lamented that it was rather difficult to understand insurance companies and their financial statements. This article aims to help investors to understand insurance companies better and thus make the right investment decisions.

Business Model

An insurance company basically agrees to take the risk of an individual in exchange for a price. Insurance companies make profits by charging the right price for the risk they undertake (Underwriting) and also by investing the large pool of funds they collect in terms of premiums.

Income Statement

The key metrics in the income statement of an insurance company are:

* Gross Written Premium/Sales (GWP) The amount of risk premiums an insurance company has underwritten in the period of the financial statement. In 2006 Union Assurances (UAL) GWP was Rs. 4.1 billion whereas Eagle Insurance wrote Rs. 4.8 billion worth of premiums

*Reinsurance and Net written Premium — Insurance companies will pass some of their premiums to other insurance companies to reduce risks. This outflow of premiums is known as ceding reinsurance. Net Written premium = GWP Reinsurance Ceded. UALs NWP was Rs.3.1 billion whereas Eagle was at Rs 3.7 billion

* Net Earned premium- All written premiums may not be earned over the period of the financial statement. This is because customers would pay premiums in advance. The part of the premiums which are earned over the financial statements duration are known as net earned premiums.

* Investment Income and Other income An insurance company will receive significant amounts of cash from policy holders. It will invest the cash. Investment income therefore becomes a significant line of income for an insurance company. UAL had earned Rs 0.7 billion investment income in 2006 vs Rs 1 billion which was earned by Eagle. Other income would be those which are earned from other insurance related activities. Often this would comprise various fees which an insurance company may charge policy holders for services provided.

*Revenue — This would be the total income earned for a financial statement period. It would therefore be the sum of Earned Premiums, Investment income and Other income. UALs revenue is Rs 3.6 billion whereas Eagle has earned a revenue of Rs 4.8 billion.

* Benefits This is the claims incurred for the period. Incurred includes both paid claims and reserve movements to Balance Sheet. In line with accounting prudence an insurance company will have to hold more or less reserves in line with changes in claims patterns and economic conditions.

* Underwriting and Acquisition costs — This would be Commissions paid in relation to insurance sales.

* Operating and Administrative expenses — These would be costs of operations of the insurance company. Eagles costs for 2006 were Rs 1.2 billion whereas that of UALs were Rs 1 billion.

Key Income Statement Metrics

The following metrics can be used when comparing between insurance companies:

Claims ratio Claims (Benefits)/Net Earned Premiums. UALs claims ratio is 74% v Eagles 42%. Other things being equal; lower the ratio better the performance.

Expense ratio Total Underwriting and Operating Expenses/ Revenue. UALs expense ratio is 36% v Eagles 31%.Combined Ratio- Measurement of how an insurance companys revenue when excluding investment income covers its expenses.

Total expenses/( Revenue Investment Income). UALs 118% v Eagles 113%. Ideally the ratio should be less than 100% and this indicates that both are making profits because of investment income and not from insurance business.

Message to the Investor

The insurance business is technical and complex when compared to other industries. By understanding the business model and the method of accounting investors can make better decisions towards shareholder value.

(The writer is an accountant working in the UK).